Cushion for Euro

Not much seems to be going right for the euro zone, and yet the euro is not just holding its ground against the dollar, where the US economy seems much more robust; it is up towards the top of the range that we have seen over the past year, or more. Does this mean that euro strength against the greenback is living on borrowed time?

It’s easy to get caught up in the news flow when trying to anticipate where currencies will move. On that score, the euro has not been performing too well as political problems mount, with the rise of far-right parties in France, Germany, and many other countries.

In addition, the economy looks as if it might be rolling over again after eking out the smallest of economic rebounds in the first half of this year. And, if reports are to be believed, there is growing disagreement about the way forward within the ECB as those stressing risks to growth push for rapid rate cuts while those with lingering inflation concerns trumpet monetary caution.

When we put all this together we can be forgiven for thinking that the euro should be on the defensive against the dollar. For while the newsflow from the US has also been somewhat mixed, few would disagree that it still looks in much better shape than the euro zone as reflected in the fact that the Fed has not started rate cuts yet. And yet, for all this, euro/US dollar remains very stable. In fact, the euro is at the upper end of the 1.05-1.10 trading range that has been in place for much of the past eighteen months. Why is it not weaker?

In our view, the answer lies in those things that do not get a lot of airtime. Things like the balance of trade and capital flows. For instance, we have recently pointed to the huge divergence that has developed between the basic balance in the euro zone and the US. This basic balance covers the sum of trade flows, direct investment flows, and portfolio flows.

In the US this has been deteriorating incredibly fast over the past year or so, while, in the Eurozone, there has been this equally incredible improvement. It is some of the most significant divergence that we have seen since the euro was born in 1999. And, if you remember what we spoke about yesterday, which was the importance of divergence in driving currencies, it seems to us that this particular trade and capital flow divergence has supported the euro against the dollar even when the day-to-day newsflow seems to be weighing against the euro.

This comes back to a point that we have made many times, which is that, while there is often this talk in the market about US ‘exceptionalism,’ meaning economic outperformance, the US actually needs to outperform in order to suck in the capital that’s required to balance out the huge trade and current account deficit at current exchange rates. If the US falls the slightest bit short in its economic performance, this black hole of trade deficits can weigh on the dollar.

In contrast, the euro zone is in such a strong basic balance position that it can seemingly lag behind the US’s exceptional economic performance and still see its currency hold its own against the dollar. This observation could relate to the ‘smile’ theory for the US dollar which suggests that the greenback performs well when US growth is very strong, or very weak, but poorly when growth is in the middle. Very strong US economic growth probably helps suck in more than sufficient capital to cover the current account deficit, while very weak US growth is usually associated with a risk-off financial market environment and, that too, can draw in capital as global investors seek the safety of the dollar. When US growth is in the middle of these extremes the basic balance deficit may bite a bit, and that could be what’s happening at the moment.

Now we know the basic balance is not a subject that’s often discussed, with far more focus in the market on things like monetary policy or US exceptionalism. But just because it is passed over does not mean that it is unimportant, and, in or view it is very important at the moment because the divergence between the US and Eurozone is so huge. If we were to use this as a basis to forecast where the US dollar might go in the future, what would we conclude? We’d argue that the US dollar is likely to fall.